A TEMPEST IS CLOSE UPON US

“How beauteous mankind is! O brave new world that has such people in it!” said Miranda.
“Tis new to thee,” replied her father, Prospero.

“Our Brave New World” is the title of the book written by Charles Gave, Anatole Kaletsky, and Louis-Vincent Gave of GaveKal Research[i]. GaveKal is an international economics research firm. Our Brave New World is a book the Author read over the Christmas Holiday. The central thesis of the book is that structural changes in the world economy and the manufacturing industry could ensure that US and European countries maintain their dominance as designers, marketers and financiers of the worlds goods and services, while China and the rest of the developing world will perform the low profit tasks of manufacturing and routine service provision. This relationship has been paraphrased as “They sweat, we (US, Europe) think.”

The authors of Our Brave New World are bright and literate men. They are no doubt aware of the quote’s source in Shakespeare’s “The Tempest” (and Prospero’s sardonic reply to his wide-eyed daughter). They must also be aware of the Aldous Huxley novel of the same name, a statement of uber-industrial dystopia[ii]. So it is with this title they develop their argument that the US (and Europe) can outsource their manufacturing and routine service industries, buy imported goods and services with increasing US debt, and continue to grow the US economy. Nice work, if the US can keep it.

ITS DIFFERENT THIS TIME

At least the GaveKal authors start their arguments with the revelation that it is “different this time”[iii]. Having shown their hole card, it is up to the critics to beat their hand. It is a strong hand but the Author fears the world not so brave and Prospero more correct in his sage resignation. [iv]

The last time investors heard that “things are different this time” was the run-up to the 2000 tech-stock bubble. Things weren’t different that time and the market punished those of misplaced optimism. That is in the nature of capitalist, mean-reverting markets. Markets overprice and underprice, swing high and swing low, but always revert to mean valuation. So telling grizzled investors and even guarded optimists that “things are different this time” is no mean feat. But we must also recognize that sometimes, just sometimes, things WILL be different.

The GaveKal authors assemble many disparate and interrelated sources of evidence. They make a good case. The next few posts will examine some of the main arguments that we are in a “Brave New World”, and some arguments that fail to convince.

THE PLATFORM COMPANY STANDS ABOVE THE COMPETITION

The new business model that GaveKal elevates is the “platform company”. The platform company is a multinational organization that does most everything required to bring a product to market except actually manufacturing the product. The platform company retains the high-value, knowledge-based activities such as research and development, design and engineering, marketing and post-sales activity. Examples of “Platform Companies” are Wal-Mart, Dell, Carrefour, the French\European retailing giant, and IKEA, the Swedish home furnishings retailer. Using Dell for example, Dell designs the computer, markets it, sells it and supports it. But the actual sourcing of the components is sent to China, Taiwan and elsewhere.

The actual manufacturing of the product is outsourced to Chinese or other manufacturers. Manufacturing is outsourced because it is currently cheaper, and will generally continue to be cheaper, in the developing countries, especially China. The type of manufacturing the Chinese and the Asians are doing is low-margin, high capital cost activity. GaveKal argues that it is also very competitive and there is little room for attractive profit margins. And if the Chinese don’t want the work, there will always be the Indians, the Malays, and the Indonesians.

HAVE THE ACCOUNTANTS OUTSMARTED THE INTERNATIONAL ECONOMISTS?

GaveKal gives an interesting example in the book. Assume Dell sells a $700 computer system. The computer package is comprised of the following parts:

Flat Screen Monitor made in Taiwan. Price $300. The Taiwanese manufacturer makes $30 profit.
Computer hardware (box, motherboard, ect.) made in China. Price $100. The Chinese manufacturer ekes out a $5 profit.
Intel microprocessor chip. Designed in the US but built under contact in Taiwan. Cost $70. $35 profit goes to US company Intel and $5 profit goes to Taiwanese chipmaker.
Windows Operating System. Designed and reproduced in the US by our old friends at Microsoft. Cost $200, $180 profit to Microsoft.
Sales Markup for Dell. Dell keeps a $30 profit for selling the PC.

Accountants would divvy up the profit as follows:

US economy. $245 Profit (Intel $35, Microsoft $180, Dell $30).
Asian economies. $40 Profit (Taiwanese monitor manufacturer, $30, Taiwanese chip maker $5, Chinese computer builder $5).

Under this analysis, US companies make $205 more than the Asian companies and an American consumer gets a cheap PC. In the case of Dell, it is a “cheap PC”, but that is another article!

A balance of trade analysis would see it differently, however.

Imports: $470 (cost of flat screen monitor, computer box and chip)
Exports: $0

Under this balance of trade analysis, each computer contributes $470 to a current account deficit. Yet American companies earned a nice profit on the transaction. And as Americans, would we rather earn $245 on a $ 700 sale, a 35% profit, or just $40 on a $470 sale (8.5%)?

Outsource Manufacturing, Outsource Volatility

The GaveKal authors take a look back at the manufacturing-based economy of the United States and note the boom and bust cycles then endemic to a manufacturing economy. Economic expansion is followed by low unemployment, fast economic growth, inflation, overcapacity, recession, and unemployment. And the cycle starts over again. The growth of the US economy, as tracked by gross domestic product (GDP), follows a similar roller coaster.

But as the US economy moves from a manufacturing base to a service and a “platform economy” base, unemployment stabilizes at a lower level and GDP volatility narrows. Many of the high-paying manufacturing jobs have been replaced with lower-paying service jobs, but the positions are more stable and the wages more predictable. And it is this predictability of wages, notes the GaveKal authors, that permits deeper mortgage and consumer debt levels for American wage earners. So along with the manufacturing, the US is outsourcing economic volatility to China and the developing economies.

VOLATILITY MAKES FOR NICE TRADING RESULTS, BUT CAN DAMPEN OVERALL GROWTH RATES.
WHAT GOES UP FAST GOES DOWN FAST

Let’s put ourselves in the shoes of the Taiwanese and Chinese manufacturers. We are manufacturing low margin products that have high fixed capital costs. Any changes in demand for the products or our costs will quickly threaten our already slim margins. And since we our manufacturers, most of our workers are variable costs, costs that we quickly shed when business slows. We don’t make large margins, we have to hire and fire our workers frequently, and we still have lots of competition. Not an enviable position.

But we are not stupid. We are sitting in Qingdao, Shandong Province, reading GaveKal’s books and thinking to ourselves, what if our company becomes a Platform Company. In less than 20 years we have gone from making bicycles to making computer motherboards. What is to stop us from moving up the economic food chain? The Author believes that this is may be the ultimate weakness in the GaveKal argument. The Chinese and the Asians will not be content with the grunt work for long. They will figure out how to market and sell to Americans and Europeans just as the Japanese did. And the American and European Platform Companies will be fighting for every penny.

This is a lot of material for one post. In the next few posts we will revisit some of these topics and open up some new ones. There are great changes afoot and as investors we must stay in front of them.

THE DOLLARS RISE IN THE EAST

Asian and some international investments have been rocketing ahead in the first few days of 2006. The Author’s Quantum Multiplier Portfolio contains a 20% holding in EEM, the Emerging Markets Exchange-Traded Fund (ETF), a 20% stake in EWY, the Korean ETF, a 5% state in ILF, the Latin American 40 Index ETF. The Author is also considering a position in EWJ, the Japanese Market ETF.

Here are the early returns as of about noon EST on January 5, 2006:

EEM Emerging Markets- 24.99% (Since Nov. 30, 2005)
EWJ Japan- 14.10% (Since Nov. 30, 2005)
EWY Korea- 39.45% (Since Nov. 30, 2005)
ILF Latin America- 52.70% (Since Nov. 30, 2005)

WE HAVE THE FUNNIEST ACT CALLED THE "ARISTOCRATS" HERE IN THE DESERT OF THE REAL!

[i] www.gavekal.com
[ii] And who gets which Brave New World. In Huxley’s novel, “Brave New World”, people are engineered and bred for certain roles in life. Alphas are the educated elite, Betas are administrative and clerical, while Epsilon semi-morons are a class of proles that do the nasty work of keeping the machines and production engines running.
[iii] “Our Brave New World”, p. 2. The Authors didn't wait very long!
[iv] The Author does find much merit in the GaveKal book and believes most of its claims to be accurate and hopes that the economic model proposed by GaveKal is the more correct one. The US current account and capital account situation is untenable and it seems that is must end in a deeply recessionary fashion. If there is a different outcome, the Author wishes to share it with his readers.